In the past five years, a new type of financial advisor has emerged to compete with traditional investment advisory firms. Funded by venture capitalists, these new advisors exploit the latest technology to offer competent investment advice in exchange for drastically reduced fees.
Just as technology changed the full-service brokerage industry by lowering transaction costs and enabling online trading, it will also ultimately change the practice of investment advisors by automating portfolio management and investment advice. According to Grant Easterbrook, analyst at Corporate Insight, “These newcomers offer average Americans access to low-cost advice and investment solutions with fewer potential conflicts of interest and greater performance transparency.”
The Rise of the Virtual Advisors
Automated online portfolio management services – what many have dubbed “robo-advisors” or virtual advisors – have been available for the past decade. They offer convenient, transparent portfolio management for accounts both large and small through easy-to-use websites – and all for 20% to 30% of the cost of traditional advisory firms. According to Institutional Investor, Corporate Insights estimates that this group currently manages almost $17 billion in U.S. assets.
Robo-advisors generally share a common philosophy of money management:
Passive Investment Strategy
Based on the concepts of Nobel Prize-winning economists Eugene Fama (Efficient Market Hypothesis) and Harry Markowitz (Modern Portfolio Theory), robo-advisors do not attempt to “time the market” by projecting its direction up or down. Nor do they try to pick “winners” and “losers” of individual stocks. They invest in broad sectors of securities or market indexes – exchange-traded funds (ETFs) – to diversify risk and secure average stock market returns.
Robo-advisors rely on proprietary software to automatically create and maintain portfolios of index funds. These portfolios are designed to fit broad client investment goals, and are tailored to factors such as age, risk tolerance, expected retirement date, and so on. For example, the criteria to select a specific portfolio might be based upon a goal, such as retirement, to be achieved by a certain future date, with the ratio of equity to debt securities based solely on the time-frame between the investor’s current age and retirement age.
Extended Investment Term
According to Betterment, an analysis of the Standard & Poor’s 500 Stock Index between 1928 and 2014 indicates that the longer people stay invested, the less loss they risk and the greater their possibility of gain. For example, about a quarter of all one-year investment periods between 1928 and 2014 experienced losses in value, while less than a tenth of the 10-year investment periods resulted in a loss. Similarly, the median cumulative return was substantially greater for 10-year holding periods than one-year periods. In other words, the longer you stay fully invested in a broadly diversified portfolio, the greater your chances of gains.
Ongoing, Pre-programmed Rebalancing
The ratio of different ETFs within a portfolio is designated according to the client’s age, goals, and risk tolerance among other factors. However, as individual elements of the portfolio outperform and under-perform their counterparts, the ratio skews from the original. For example, a recommended portfolio of ETFs might include a position in Vanguard’s U.S. Large-Cap Value Stocks ETF (VTV) equal to 12% of the total portfolio. Due to market conditions, the Vanguard Large-Cap ETF outpaces other ETFs and grows to 20% of the portfolio value. Rebalancing requires selling almost half of the Large-Cap ETF and reinvesting those proceeds in other ETFs in the portfolio to restore the original ratios. By constantly and automatically reviewing the portfolio mix and taking corrective actions, robo-advisors can maintain the balance suited to a particular investor’s desired risk exposure and profile.
Intelligent, Automated Tax Management
Virtual advisors generally employ programmed rules to maximize short-term losses while maintaining full exposure to market increases and avoiding costly “wash sales.” Samuel Lee, a market strategist at Morningstar, believes the virtual advisors’ superior tax-loss harvesting service is especially beneficial for high-income-taxable investors. For example, one robo-advisor, Betterment, suggests its proprietary tax loss harvesting program can increase total returns by 0.77% annually.
Examples of Virtual Advisors
The following list of automated online wealth management firms is not intended to be complete, but rather representative of the more than 120 services presently available. The industry is constantly evolving with new services and entrants:
General Characteristics of Robo-Advisors
While virtual advisors differ between targeted clients, fees, minimum portfolios, investment flexibility, and level of customer service, they share many common attributes which vary primarily in degree.
1. Attractive, Easy-to-Use Websites
Unlike the vanilla, complex websites of traditional investment advisors and Wall Street firms, virtual advisor sites are designed to be intuitive, user-friendly, and easily navigable. The liberal use of pictures, videos, and interactive displays combined with easily understandable explanations of processes and technical subjects provides a comfortable viewing experience. Many robo-advisors have platforms on a variety of electronic media, including smartphones, so clients have 24-hour access wherever they are.
2. Convenient Enrollment Procedures
Accounts are opened following completion of a simple online questionnaire to collect demographic data (name, address, Social Security number, age, etc.). Robo-advisors typically collect additional basic information about risk tolerance, investment goals, preferences, and probable terms.
3. Taxable and Tax-Deferred Retirement Accounts
The majority of advisors offer basic investment accounts as well as rollover and traditional IRAs and 401ks. Some, such as FutureAdvisor, recommend tax-deferred accounts at the client’s request, even though these accounts are not managed by or in the custody of the advisor. Virtual advisor Blooom specifically targets 401k accounts.
4. Minimum or No Required Investment
Some advisors do not require a minimum balance. Instead, they offer their recommendations for a minimum monthly fee, while others require either a low initial deposit or an agreement to auto-deposit a fixed minimum sum monthly.
5. Commercial Bank Account Linking
Linking to clients’ commercial bank accounts facilitates transfers to and from the managed accounts. This is particularly advantageous – and may in fact be required – where the advisor has the responsibility of executing trades on the client’s behalf.
6. Account Aggregation
Some virtual advisors aggregate all of a client’s accounts – even those outside the custody of the advisor – to provide a total view of the client’s position and a coordinated strategy to meet specific goals. Others, however, confine their recommendations to the specific accounts created through the virtual advisor.
7. Reliance Upon Complex, Proprietary Computer Programs
Computers and Wall Street are a marriage made in heaven. Whether enabling millions of security transactions around the world or identifying specific profit opportunities by the analysis of those transactions, computers and their complex software programs are integral to modern investing. All virtual advisors rely heavily on proprietary investment algorithms to allocate and maintain portfolio holdings optimized for their individual clients.
8. Reduced Management and Transaction Fees
Total investment returns are often significantly reduced by transaction fees (commission on trades) and investment management fees. The typical investment advisor charges 1% per year of assets under management – robo-advisor fees typically average 0.25% of portfolio values or less. In addition, many robo-advisors invest exclusively in commission-free ETFs with low expense fees.
9. Restricted Investment Options
All virtual advisors operating to-date limit the choices available to their clients to some degree. As investment choices, terms, and historical data expand, the number of calculations necessary to reach the optimum portfolio increases geometrically. A limitation of investment choices is necessary to reduce both costs and complexity to a manageable level. Robo-advisors generally use a limited universe of ETFs, mutual funds, or predetermined portfolios designed to accomplish specific investment objectives. A few allow individual stocks and bonds as part of the portfolio mix. Currently, no robo-advisors consider non-securities such as real estate, commodities, or options in their recommendations.
10. Control Over Trades
Virtual advisors are regulated as “registered investment advisors” (RIA), a required distinction when charging fees for investment advice. Some advisors may also be associated with broker-dealers, regulated by the SEC and FINRA. The latter distinction allows the advisor to act as custodian for the client’s securities and provides up to $500,000 of insurance in case the broker-dealer fails. Some robo-advisors act solely in an advisory capacity – clients maintain the option to implement recommended trades in their own accounts. In other cases, virtual advisors require trading discretion over client accounts so they can buy and sell securities without prior approval, as in the case of automatic rebalancing of accounts offered by many robo-advisors.
11. Transparency of Activity
Virtual advisors usually provide detailed, up-to-date information on any action taken that affects a client, including the precise number of shares bought, sold, or held in an account. Since they generally rely upon their websites to attract customers, virtual advisors try to provide all information consumers might need to enroll in their service. The Paladin Transparency Index rates the quality and completeness of financial advisors’ public and client information.
12. Limited Personal Attention
The majority of robo-advisors do not meet face-to-face with clients, nor do they provide significant personal investing advice or general financial planning services. Instead, they rely upon the completeness and ease of use of their websites. The ability to customize recommended portfolios varies from advisor to advisor. However, a great many offer a combination of chat lines, email, and limited 800-number telephone access for customer service and administration.
13. Extensive Client Reporting
Electronic and paper copies of account statements, trade confirmations, account and commercial bank activity, portfolio positions, and detailed tax information are readily available, including historical information. Some advisors provide formatted electronic information which can be used easily with popular income tax packages or personal finance software.
14. Account Security and Privacy
The majority of virtual advisors have roots in the computer and math fields, rather than investment advice. As a consequence, their online platforms are complete with Internet security, including 256-bit SSL encryption, dedicated servers in secure facilities, and robust, redundant systematic procedures to protect data.
The Future for Robo-Advisors
The largest firm in the category, Wealthfront, has more than $1 billion of funds under management. The majority of these are enjoying double-digit growth, providing services to young and lower-net worth individuals who lack the time, training, or interest to manage their own investments. Millennials are the first generation to be born with computers in their homes. Because they operate with ease in the digital age, they are more comfortable with the lack of human interaction present in the virtual advisor model.
Having disrupted the pricing of advisory services, some new entrants are adding human advisors to supplement their digital services. While the virtual advisor model is constantly evolving, the industry’s long-term growth and stability depend upon the actions of other players in the investment advice world.
Apathy of Traditional Investment Advisors
According to a recent report by PriceMetrix, traditional Wall Street advisors who actively manage investor accounts had a very good year in 2013. The assets under management for the typical manager grew to over $90 million, up 12% from 2012.
However, this success masks some fundamental changes that are taking place in the industry:
- Much of the growth was the result of strong stock markets, rather than new clients – the S&P 500 grew 26.4% during the year.
- The average fee collected per account has dropped from 1.21% in 2011 to 1.02% in 2013.
- Advisors are abandoning small accounts (less than $100,000 in investable assets) for larger accounts.
- Advisory clients are getting older – averaging 61.1 years in 2013 versus 60.5 years in 2012 – and have larger portfolios ($562,000 in 2013, and $435,000 in 2011).
- Slightly under half of advisors’ revenues come from fees (47%); the remainder come from commissions on trades performed for their advised clients.
- While more than half (53%) of retirees use a dedicated personal financial advisor, only 40% of those yet to retire have one, according to a recent Gallup poll. At the same time, almost one in four (24%) working investors use an investing website – substantial growth is possible as more investors both gravitate toward these online platforms and hire advisors.
- According to the 2014 Wells Fargo Millennial Study, millennials – those born between the early 1980s and early 2000s – are less likely to trust “personal finance experts/personalities” than the previous generation, as reflected in the smaller percentage who use financial advisors (16% of Millennials versus 30% of Baby Boomers). Three out of ten of both generations consider management fees “too high.”
Investment advisors who actively manage account portfolios are largely ceding the market of beginning and lower-net worth investors to their new digital competitors, even as they suffer a reduction in management fees.
Benefit to Financial Planners
Despite the tendency to equate investment advisors with financial planners, robo-advisors are not financial planners and offer few services beyond passive, automated portfolio management. The charges for robo-advisor services are necessarily low, usually 0.25% or less, so that customized solutions for individual clients are not financially possible.
Financial planners, though more expensive, frequently perform extensive analysis through face-to-face meetings with their clients, giving advice on such matters as budget, tax, insurance, and estate planning. Many financial planners recognize that virtual advisors are compatible, not competitive with their services – they manage portfolios for less money than their actively managed alternatives. Those advisors are moving to incorporate robo-advisors into their practice, a perfect example of “If you can’t beat them, join them.”
Technology, formerly limited to the back office, is rapidly becoming a competitive requirement of client management. Utilizing the services of virtual advisors is a way to bridge the gap inexpensively.
Threat of Discount Brokerage Firms and Mutual Fund Managers
Recognizing the potential of virtual advisory services – specifically the value to the next generation of investors – the larger discount brokerage and portfolio management firms are expanding or adding automated investment advice to their services for little or no cost to the consumer. Vanguard’s new Personal Advisor Services (VPAS) was introduced in April 2014 for investors with portfolios of $100,000 and up, for a fee of 0.3% of asset value. In October 2014, Charles Schwab & Co., one of the larger discount brokerage firms with nine million active accounts, announced a new free, online advice service as well.
While automated investment advisory services provide definite benefits to the investing public and are certain to remain part of the financial landscape, they may be “too much of a good thing.” As more companies develop robo-advisor services, it is unlikely that every current robo-advisor can survive as an independent firm.
Despite the huge market for their services, the current level of fees is unlikely to generate the revenues necessary to achieve significant profitability. For example, $1 billion in assets under management with a 0.25% management fee generates annual gross revenues of $2.5 million, hardly enough to cover the costs of ongoing operations. As a consequence, the industry is likely to consolidate, with some firms merging, others being acquired by larger, traditional investment managers, and some simply disappearing. Potential clients of a virtual advisory firm should be aware that change is coming and select an advisor with strong financial backing, industry leading technology and customer service, and a likelihood of being one of the winners left standing.
Would you use the services of a robo-advisor?